[00:00:00] Speaker A: The markets. We just can't get enough of them.
[00:00:03] Speaker B: Markets are the drivers of your wealth and investment strategy.
[00:00:07] Speaker A: Welcome to Magic Markets with your co hosts, the finance Ghost and Mohammed Nallah.
[00:00:13] Speaker B: Together we have more than 25 years of combined experience in the markets.
[00:00:17] Speaker A: For those looking to take their market and business knowledge to the next level, we offer Magic markets premium. Our recent research reports have included Costco and Walmart as retail giants, Airbnb and Meta as platform businesses. Take two interactive and Crowdstrike as examples of technology companies that may not be near the top of your list and unusual players like a Cushnet in the golf industry. For just 99 reals a month, you get access to the entire library of our research. Visit Magic Dash Markets.com today and go premium welcome to episode 194 of Magic Markets. The past couple of weeks have been really fun. We first did how to build a bull case for a company, and then we did how to build a bear case. Actually, very different techniques required. In the first one you can listen to management a lot, and in the second one you have to pretty much ignore management and come up with ideas on what can possibly go wrong. And in that show, Mo, we made reference to a number of important things that you need to look at in the financials. Now, if you're unfamiliar with even how to read an income statement, balance sheet, statement of cash flows and everything else, that's quite difficult to do. It's quite difficult to do. Anyway, let's be honest. But I think the more we can expose our listeners to what some of these things are and how to look at them, the better their chances of being able to find success in the markets. So today, Mo, we are doing the income statement, which is a good place to start, because that is the lifeblood of any company. And don't worry, this is not going to sound anything like an accounting lecture. I left those days behind me a long time ago.
[00:01:46] Speaker B: So I have to chuckle with your accounting background, because today's topic is really part of that how to series we're doing, you know, how to build a bull box, how to build a mailbox. And I think it's important because bull and bear box can be very macro at times. I mean, again, if you go and listen to those two previous shows, you'll see there are a lot of macro points that feed in, but quite often you have to dovetail that with an on the ground look at what a company is doing. And one of the foundational building blocks, again, even if you're not familiar with financial analysis, is you've got to look at the income statement as well as the balance sheet. So this week, looking at that income statement and goes. Going to jump in first because I do take a more macro perspective on things. Even when we started out with the bull in the bear box, and I take the same approach when looking at an income statement. We will get into the weeds, we will look at specific line items and we'll unpack some of those for you on the show today. But my very first go to is I look at the revenue line, because that's the easy one. I look at the revenue line, I look at revenue growth going back several years, not just the last quarter. Remember, management wants you sometimes to focus on just period where they look the best. So go and look at it yourself. Objectively, we use ticker. That is a great platform where you can actually access a lot of the company's financials. But alternately, you can go onto the corporate website, you can actually pull the financial statements directly from the corporate website. So I start out at the top line looking at revenue growth. Is a company growing? Is it not growing? I then also look at the various margins and I start out with gross margin, then we look at operating margin, then we look at net margin and we'll get into the nuances and the differences there. But the reason I look at this, just on a macro level to start off with is a company can be growing revenues, but if it's actually doing that less efficiently, if the margin is shrinking, it stands to reason that they will be making less money. So you've got to look at how does the interplay between the top line and how the company's actually executing on that top line come through. And that is my starting off point when looking at an income statement goes.
[00:03:37] Speaker A: And that's why the income statement is so important, right? I mean, you can have the strongest balance sheet around, but if the income statement is poor, then you're basically just sucking that thing dry over time. Equally, the balance sheet might not be great, but if the income statement has made a lot of progress, then that can fix a balance sheet over time. And that is exactly what does fix a balance sheet over time. So I think ill touch on some of the things we would look at when were doing this top down analysis of an income statement. Because you do need to start with revenue. I mean, that is the lifeblood of the business. At the end of the day, if the revenue story is poor, then there are bigger problems, honestly. And the most important thing is to just drill down into the detail as soon as possible in your process. Don't be too focused on the company coming out and saying, oh, you know, total revenue was up 7%. That's great. What do we do with that information, really? We need to understand why. One of the main things actually, because if the company has done transactions recently, if they've made any acquisitions, they've effectively artificially boosted that growth rate by taking cash off the balance sheet and going and buying revenue. They've got an acquired a company, they recognize the revenue, it wasn't in the base period, and they boost their growth rate. You can be caught out by that quite badly. So one of the first things to go look at actually is are there any acquisitions that are in this period and not in the base period that are making it hard to really compare the growth rate? And you'll see that come through in metrics such as like for like growth or comparable growth versus total growth. Always look at both if they are there, and then always go down into things like the divisional splits. Go and look at the segments. You know, we mentioned that on the bear box show last week where we talked about the importance of actually going and looking if there's a black hole anywhere. In this case you're going and looking for the good news too. You're going and seeing what is doing really well. Geographical splits as well. Very important. Go and understand which segments have been performing and not just in the latest period. If you're doing this properly, you need to go and pull the numbers for the last couple of years. And in the case of the US, where they release quarterly, that can mean, you know, eight different sets of financials where you need to go and pull a number from. Or if you have a trading system that has that kind of data, you can pull it there. But I don't really trust the divisional data on a lot of those things. You generally need to go get it straight from the financials and actually go and do some trend analysis on each one to understand how the business is really performing, not just what management is telling you.
[00:05:52] Speaker B: Indeed, Ghost, you touch on such an important point because you touch on the segmental analysis as well as the geographical split. And quite often you've got to look at that geographical split because we're looking at global companies here. You need to see where's the growth coming from. Is this an emerging markets growth story? Is all the growth coming from the developed markets? And I want to tie this back to some of the work we had done in the bull and the bear box, because you've got to look at that with a macro lens. You've got to say, is the company growing its revenue in the high growth areas, or is the company actually struggling there and leaning too heavily on its core markets, where the macro picture might telling you you've got a much more stable growth profile. So that's kind of rounding out the discussion on the top line. Where I'm going to go with my next point, Ghost, is looking at the costs in the business, because when you look at an income statement, you've obviously got the revenue line that's right at the top, but you've then got to look at the cost of goods sold. Now, quite often these are the direct costs associated with producing those goods. So effectively, if you actually take revenue and then you take the cost off generating that revenue in terms of the cost of goods sold, the differential between that is how you get to your gross profit or your gross profit margin. And that's the point that I also looked at in my very first point, is, is the company generating its revenue or generating its profit, its gross profit margin in a sustainable manner? This tells you about the overall health of the underlying business. Is it more or less efficient? And it's a vital point in terms of informing what the investment outlook looks like. You can definitely have revenues that are growing at a very respectable rate. But if it's actually costing the company more to generate that revenue, going to actually see that start to come through in terms of the gross profit and the gross profit margin. Now, I don't want to go below that line because obviously, once you go below gross profit, you've got to start including things like SG and A or marketing spend. We're going to get into some of the weeds there. And quite often, depending on which sector you're looking at, you're going to have very differential results coming out here because you've got some companies that operate an asset light model, you've got some companies that operate with very large R and D or research and development budgets, and that starts to come through below the gross profit line.
[00:07:57] Speaker A: Yeah, absolutely. And there are really sector specific things as you've touched on. I mean, one of the ones in retail, for example, is shrink. We saw that in the last couple of years as a key feature of the us retail market. Shrink basically means a combination of wastage. So that's more for your sellers of perishable goods like fresh fruits and veggies. But really it means theft. And that's been the trend in the US in the past couple of years. It started to get better now, you had general merchandise dealers, pharmaceutical product dealers, health and beauty, really struggling with shrink. You would see that come through in the gross margin. And of course, the net of those two things of revenue and cost of sales is gross profit. And that is actually a more important growth rate, in my opinion, than revenue, because it doesn't help you if your revenue is growing really nicely, but your cost of sales are going up faster than that, and your gross profit margin is deteriorating. It means your gross profit itself, which is the thing you use to pay expenses, will then be growing at a lower rate than revenue. Likewise, if your gross profit margins are getting better all the time, then your gross profit growth will be higher than your revenue growth, which is great. Just be skeptical of gross profit margins getting bigger and bigger and bigger. There is definitely an end to that. Technically, they can go to zero if a business is unbelievably inefficient, but they can't go to the moon because. Because at some point a competitor will come in and undercut them, and those margins will have to come back down to earth. And that's a point we raised in the bear box. You've got to be very careful about assuming gross profit margin expansion into infinity and beyond.
[00:09:23] Speaker B: Yeah, indeed, Ghost. And I think now is a good time to move beyond gross profit, because gross profit is literally just looking at the revenue, less the cost of producing the goods, but it doesn't look at some of the other operating expenses. And this is where the term comes from, operating expenses. Once you subtract that, you get to the operating income and the operating income margin. Now, what goes into operating expenses? This is, as I mentioned, you'll get selling general and administrative expenses. You know, sometimes you've got your head office costs that come through there. We've got research and development, and effectively, those are costs that the business can't really get away from either. So it's not directly tied to the production of the goods, but they are the general overheads in the business. Now, when you're looking at this, it's why we look at the gross margin. You look at the operating margin, and then the last point we'll touch on is obviously the net income and the net income margin, because there are a couple of points that come further down the income statement, just below the operating margins and the operating expenses. But looking at that, operating income is really a very important measure because it really, for me, wraps up what is the company doing with its core operations in general, it strips out the financing aspects, it strips out the depreciation aspects that all comes further down the income statement. So for me, operating margin and operating income is really a pure view on how is the company doing on the income statement specifically. It takes out some of the aspects that really start to bleed into the income statement from the balance sheet and is a really critical metric when assessing a company's financials goals.
[00:10:52] Speaker A: Yeah, absolutely. And when we look at the operating expenses, you know, there really are so many different things that we actually need to consider. You can go through a whole show just on that, really. But some of the stuff that I certainly always look at is just that, the administrative costs line, definitely, but staff as well. And that was something that was a real feature of the us market in the past couple of years. The tech companies especially got unbelievably bloated, and then they had to cut back. Shock and horror. So I think meta was one of the best examples of this. But there were plenty of others. I think Amazon was another, you know, where the margins just got to a point where the market was kind of tired of listening to management's big promises about it and pushed back and said, you guys need to get this place in order. And so they did. And the losers in all of that are the staff who get retrenched, and then suddenly they come out with numbers where margins have gone the right way, and you see the share price jumping 20 or 25%. And the quick test for this is to actually just look at whether or not the EBITDA, and we'll get to that. Now, whether the EBITDA growth rate is higher than the revenue growth rate. If it is, you know, margins went up. It's a simple test. It's in the maths. If revenue was up 5% and EBITDA was up ten, margins went up. Similarly, if the EBITDA growth rate went down, or rather if it was slower than the revenue growth rate, then you know that margins have gone down. And EBITDA just stands for earnings before interest, taxes, depreciation and amortization. So that's the acronym. Basically what it means is profit before the balance sheet stuff gets in the way. Depreciation, for example, should never be ignored. But it is a very subjective thing. The depreciation policies can be rather volatile. You know, companies choose the useful lives of the assets, et cetera. And so that's why depreciation, et cetera, can really skew an income statement. And by taking that out, we have a bit of a cleaner view on operating profit in terms of a cash basis. We also then ignore, as I said, interest, which means we're not too bothered about how the thing is funded and we're ignoring taxes. Again, something to be careful of. But, you know, that will depend on a whole myriad of factors, somewhat outside of the company's control. So the private equity industry, when they do deals, they do it based on EBITDA because they will change that balance sheet as part of the deal. They don't really care about what it looks like today, and they don't want to see the non cash distortions like depreciation. They just get in the way of their modeling.
[00:13:10] Speaker B: Yeah, indeed. Go some very important points there. It's why, from an efficiency perspective, I generally look at that operating margin because, like you say, that's really where you determine whether a company is getting better at actually running their core business, but now dropping below that. Let's look at some of the other items on the income statement that basically take us from the operating income all the way down to the net income margin. And as you've indicated, you've got the depreciation, stuff like that that comes through. But the important one I want to mention here is that you've also got to look at things like interest expense or interest income there. Also the gains, for example, or losses, for example, from investments. And we mentioned the exceptional items when looking at the revenue line, because sometimes companies go and buy, they acquire companies, they go and buy their revenue. But the same thing can happen further down in the income statement. And that's where, for example, a company had acquired an equity stake in a subsidiary and then maybe sell that off. And what happens there is that you get these very large one time swings. They either sell it off or you actually see them take a loss on that investment, and that can swing or create a very large differential between your operating margins and your net income margins at the end of the day. So that's one that I look out very, very closely, simply because there's sometimes a lot of corporate action that comes through. You're not going to pick that up at an operating level. You're only going to pick that
[email protected]. income level. And if you're looking at a company at a specific point in time, that's just a snapshot. They may have gone through a quarter or two where there was a lot of corporate action. Maybe they had these large outsized gains coming through from the sale of assets or the sale of investments. You've got to pay attention to that. You've got to actually strip that out when you're doing your analysis to look at what is the underlying growth in the company doing? What is the underlying performance? So pay attention to some of those metrics. One last point I want to land on here, Ghost, is then I
[email protected] income line. But then also, how does that actually move through to an earnings per share line? Because quite often it's not static. Companies can either be buying back shares. We see that share buybacks are very prominent in the US. Share buybacks generally good for earnings per share. And so you pick up a differential sometimes between the earnings per share versus the actual performance of the company. But the inverse also applies. If a company needs to show up its balance sheet, it goes out there, it issues shares, and that can actually be dilutive to shareholders and equity holders on an earnings per share basis. And that, for me, is also a very important metric that kind of dovetails the balance sheet, but also reconciles it to what you're seeing on the income statement.
[00:15:34] Speaker A: Yeah, and I mean, this is very much a whirlwind overview, but hopefully it shows why you can see such a different growth rate in earnings per share versus revenue, because there's just so much that happens in the middle. Margins will change. Debt is another thing we've barely touched on, which comes between finance costs. Now, that happens after EBITDA, before net income, if your debt has really gone up or the cost of debt has gone up, that's going to put pressure on your net income relative to your revenue growth. Similarly, if you have less debt, or if the cost of debt has come down, and that's hopefully what we'll see in the next couple of years, it's going to boost net income and earnings per share as opposed to revenue growth. The one thing I just have to give a dishonorable mention to as we bring the show to a close, is adjusted EBITDA. Us companies love adjusted EBITDA because it has one great trick. They can reverse out those irritating, pesky share based payments. Now, basically what this means is they take their staff and instead of paying them enough in cash, they say, hang on, we are a listed company. You want to be one team, one dream? Here are some shares. This is part of your remuneration package. Now, if the shares were a relatively modest part of that package and it didn't add up too much, it wouldn't be such a big deal, unfortunately. Fortunately, in terms of alignment, you know, that's a story for maybe another show entirely. They actually pay a lot of shares out in lieu of cash bonuses. Now, what this is doing over time is it is basically diluting all of the existing shareholders. There are more and more shares in issue. And then what I love most about these companies is they then say, well, we're busy with share buybacks. So what they're actually doing is they're taking cash, using it to buy back shares in the market to offset the dilution from issuing shares to staff, and then trying to tell everyone that this is not an expense for the company. And so it comes out in adjusted EBItda. It's complete rubbish. It's so that they can basically try and juke it and show that adjusted EBITDA is really good. I almost exclusively ignore it unless it's really minor. It's a lot better to look at Garp earnings. So that's generally accepted accounting practice, GAAP or Garp. That means they had to recognize the share based payments as an expense. Just have a quick look at the difference between adjusted EBITDA and Garp earnings. There's lots of other stuff between the two. They won't be exactly the same. So rather look at the growth rate in both, and you'll very quickly see how much nonsense there is or isn't in the adjustments to EBITDA. And again, this is the kind of very technical work that we do every week in magic markets.
[00:17:53] Speaker B: Premium. Yeah, ghost, I knew you were going to save that one for last because it's your bugbear and it really features so prominently in the tech sector specifically, but not exclusively to the tech sector. Again, it's just so important in highlighting, doing your own homework. Don't just buy what management's telling you on the call. It's also why at the top of every single earnings call, they give you the disclaimer. They say some of the numbers that we're going to share here are non GAAP. But you obviously, you've got the Garp as a contrast to that. And that's because companies are going to do what they want to do is they want to actually flatter the numbers. They want to look as attractive as they can to the investment community. And again, it is really for the investor that doesn't do the homework. They get caught out. But for investors that do their homework, to do your own research and the type of stuff we're doing here at Magic Markets premium, it's so important because looking at that, knowing the kind of tricks that are being played actually allows you to have a critical view of a company and whether it warrants a good investment case or not. This is obviously just looking at the income statement side of things. We'll probably do another show in the future where we look at the balance sheet. Because these two aspects of the financial statements talk very closely to one another. We've already indicated how the one does bleed into the other, and so it probably warrants another show. But unfortunately, we've actually run out of time on this particular show. We think it's given you a nice high level overview of how to look at an income statement, looking at some of the key aspects, and just understanding the games that can be played and how you contextualize when you're looking at the numbers. We hope you've enjoyed this show. Hit us up on social media. It's a pod. One word at Finance, Ghost, Hudnalla, all on X. We really do think you should go and have a look at Magic Markets premium. It's only 99 rand per month and you get this detailed bottoms up as well as top down approach in terms of a global stock. Every single week there is a report as well as a podcast, so go and check that out at 99 rand a month. We think it represents fantastic value. That's where we're going to leave it. Let us know what you thought of the show until next week. Same time, same place. Thanks and cheers.
[00:19:47] Speaker A: Ciao.
This podcast is for informational purposes only and is not financial or investment advice. Please speak to your personal financial advisor.
